The Critical First and Last Steps in a Municipal Workout: Vallejo, Harrisburg and Detroit

The first critical step in a municipal workout, whether inside or outside of bankruptcy, is to get all parties, the debtor and the creditors, to accept that they will all have to incur significant losses as a result of the workout process. Secured creditors will do better than unsecured creditors, but, taking that into account, the losses need to be fair and proportionate, and the municipality needs to come out the other end of the process able to operate successfully into the future.

Because the municipality is a public entity and a political subdivision of the state, the politics and finances of the workout are intertwined. Creditors with the most political pull or with overwhelming financial strength, compared with the debtor and the other creditors, will try to exercise that pull or strength to avoid losses and to get a disproportionately better deal. If those powerful creditors are successful, the workout will not produce a good result for the municipality or the other creditors.

The City of Vallejo, CA was in Chapter 9 bankruptcy from 2008 to 2011. Its largest creditor was the California Public Employees Retirement System (CalPERS), the state pension system which includes the city's employees. Vallejo decided that it would not ask CalPERS to take any losses because CalPERS was too big and powerful, politically and financially, for the city to fight. Vallejo slashed all of its other costs, including downsizing the police and fire forces and cutting retiree benefits, payments to bondholders and city services. Since 2011, Vallejo's CalPERS pension costs have soared, and it is possiblle that the city may again go into Chapter 9 bankruptcy. Failure to take the required first step resulted in a failed workout.

The City of Harrisburg, PA has had the opposite result. When I served as the first state-appointed receiver for Harrisburg in late 2011 and early 2012, I worked hard to prevent the major bond creditors, particularly the bond insurer, from utilizing their political influence to obtain a disproportionately good deal in the workout. I largely neutered the politics by publicly disclosing the political maneuvers. The result was a much more level playing field, and the second receiver, Gen. William Lynch, has done a tremendous job negotiating a workout that is proportionately fair to the city and all the creditors. The city has a very good chance of having a successful future.

The City of Detroit, MI is in the process of working through this first step. The recent developments have been very good, thanks to the courage and good judgment of the bankruptcy judge. The receiver came to the judge with a proposed settlement with two swap counterparty banks. It was a much more generous settlement than other creditors can expect because the receiver wanted the banks to release their lien on gambling revenues. The judge said no and told them to renegotiate the deal. They did, with the banks agreeing to take a lower payoff. When presented with this second proposed settlement, the judge again said no.

The judge was right to do so. These banks helped put the city into a terrible pension bond issue and related swaps. Later, when the transaction did not work properly, the banks pressured the city into giving the banks a valuable lien on the city's gaming revenues. But that pledge may not be legal under the gaming statute. In short, these are not sympathetic creditors, legally or otherwise, and they should not be allowed to receive a sweetheart deal.

The bankruptcy judge has given the receiver a huge gift by turning down the two settlements. It is clear that the judge will insist that this Detroit workout be done on a level playing field, and all the creditors will have to take that into account in their negotiations with the receiver. The first step is now accomplished, and the receiver can go forward and negotiate hard with the city and all the creditors to achieve a fair result.

Negotiating with the debtor and all the creditors is extremely difficult and challenging. The last critical step comes at the tail end of these negotiations: the state government comes in and adds final incentives to help solidify the whole deal.

This last step was not possible in Vallejo because the State of California is taking a hands-off approach to municipal distress. The state could have forced CalPERS to compromise, or it could have taken other steps to help the city to recover, but it chose not to. The result was a flawed and failed workout.

In Harrisburg, the state put very little on the table at the beginning of the workout. The state made it clear that it would not "bail out" the city. However, once the city and the creditors agreed to significant concessions with the receiver, the state facilitated the workout by agreeing to enter into various electricity and parking contracts which enhanced the value of the city's assets being sold or leased. The Corbett Administration handled this final step exactly the right way at the right time in the workout process.

The State of Michigan should take the same approach with Detroit. Now that the judge has signaled that there will be a level playing field, the state should let the receiver negotiate seriously with the city and the creditors. The governor recently proposed having the state contribute $350 million toward the pension portion of the workout, but it is too soon for the state to make such offers until all the creditors signal that they will contribute significantly to the solution.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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